How do RBI's policy rates impact your finances?

There was a time several years ago, when my fellow passengers in the Mumbai local trains raised an eyebrow at my reading a financial newspaper. Today, macro-economic indicators have become the subject matter of dining table conversations. Knowing that I am a teacher first, readers write to me asking for explanations. Since interest rates will be in news this week, I thought it may be useful to understand the debate regarding interest rate and what it means to investors.

Interest rate is the price that a borrower pays a lender for using the latter's money for a specific period of time. While it is easy to say that the interest rate will depend on demand and supply, it is important to know what is the basis for pricing. Assume you have Rs 100 today and can use it to buy something. Instead, you choose to lend it so that someone else can buy what he needs. He can return the money to you, say, a year later.

At that time, you should be able to buy what you had postponed. The interest you receive on your lending should compensate you for the change in prices of things you would buy. So, interest rate in its basic form is a compensation for loss of purchasing power.

The market for money is not defined by this straight-line flow of funds from the one who has a surplus to lend and the one who has a deficit and needs to borrow. The fact that money is available, may spur some people to borrow. A businessman who is considering a project, will be keen to implement it if the money is available at a reasonable rate.

A family may advance their decision to buy a house if home loans are reasonable. The demand for loans moves up when interest rates are low. This, in turn, increases the price of goods and services being bought and leads to a high level inflation. This is why Friedman said, "Inflation is almost always about money supply."

While it is nice to see that more people are buying homes and cars and businesses are setting up projects due to a growth in credit, the rise in prices due to all this activity is a matter of concern. Inflation, or the increase in the general level of prices, means that purchasing power is actually falling.

The rupee buys lesser goods than it would and people find it tough to buy what they have to. Worse, those that have to lend money find themselves in a fix. They have to now ask for an interest rate that compensates them for an inflation rate which they see moving up. They can't afford to fix an interest rate today that may be inadequate tomorrow. Lenders may be unwilling to lend for a long period and long-term business projects would be tough to implement. This is why inflation is not a good thing to have.

The Reserve Bank of India, which has the responsibility of ensuring that economic activity is well funded without overheating into an inflationary spiral, steps in. The RBI monitors various variables—the growth in savings, credit, money supply, inflation and economic growth. It steps up the interest rates when it sees inflation moving up. When it does so, it puts brakes on the borrowers and forces them to revisit their borrowings. The speed of transfer of funds from savings to deposit to credit is slowed down. Fewer cars, houses and goods are bought when interest rates are high and fewer investment projects are funded.

The inevitable fallout of this action is a slow down in the rate of growth of money supply and inflation, and ultimately, economic growth itself. Economic activity ebbs when the RBI increases the interest rates and makes it costly to borrow. Inflation also falls with this slowdown. With this, the process of reversal begins. When the RBI notices growth declining, and is confident of inflation coming under control, it begins to reduce the interest rates. The cycle of economic activity returns as households and businesses begin to borrow.

The RBI does not control the interest rates in the system. Banks are the primary drivers of credit. The financial markets have various products, such as equity, debentures and deposits, as well as several structures through which money is channelled from those who have it to those who need it. The central bank only sets the repo and reverse repo rates, or the short-term rate at which the banks can borrow or lend to the RBI, after having exhausted their attempts to borrow or lend in the markets.

A bank that is short of cash and has been unable to find a lender can borrow from the RBI at the repo rate. This rate is set by the central bank and is modified to signal its stance on how money should be priced in the system. If the apex bank increases the repo rates, this gets transmitted to the system through banks and the financial markets.